Half-Way to Lost Decade, Europe's Growth Task as Tough as Ever

Half-way toward a lost decade for Europe's economy, pessimism persists about the political will to halt a worrying slide in the region's potential growth.

Without sweeping reforms to boost productivity, Europe's output will remain sub-par, making it harder for governments to reduce debt burdens that are unsustainable financially and unemployment rates that are unsustainable socially.

Leaders of the 27-nation bloc will have another chance to cut this Gordian knot at a summit in Brussels next week.

True, the euro zone has belatedly made impressive efforts to contain its debt and banking crisis.

The European Central Bank's promise to buy the bonds of vulnerable member states if necessary has averted the threat of a break-up of the single currency.

Spain has wiped out a current account deficit that had reached 10.6 percent of GDP by 2008. Greece has narrowed its competitiveness gap by half since 2010, according to the International Monetary Fund.

And in its Spring 2013 forecast for the euro zone, the European Commission concluded that the crisis would have no impact on longer-term growth dynamics even though it had resulted in a permanent loss of output of about 5 percent.

It said potential growth, estimated at just 0.4 percent this year, should recover gradually as structural unemployment falls. Potential output is the fastest rate that an economy can sustain without generating inflation as demand exceeds supply.

Laurence Boone with Bank of America Merrill Lynch had a gloomier view, arguing that both drivers of trend growth were impaired: physical capital investment was being held back by weak bank lending, while human capital was deteriorating, as evident in high unemployment, especially among Europe's youth.

Instead of using the leeway provided by the ECB, policymakers had relaxed.

"We are not taking discretionary economic policy measures to tackle these issues, such as cleaning up the banking sector," she said. "I'm a bit more pessimistic than the commission."

GOING DOWNHILL

Youth unemployment is understandably rising fast up the political agenda. It stands at 62.5 percent in Greece, 56.4 percent in Spain and more than 40 percent in Italy and Portugal.

Economically, the scourge is a further drag on potential growth because young people are more productive than older workers. As Europe's population ages, improvements in labor productivity will be key to higher living standards.

Deutsche Bank estimates that the disproportionate fall in youth employment could reduce productivity by between 0.2 percent and 0.3 percent a year in Spain and Italy.

That sounds manageable except that Deutsche estimates long-run potential growth will be just 1.2 percent a year in Spain and close to zero in Italy in the absence of structural reforms.

On the same basis, past trends in productivity and labor market participation plus UN demographic forecasts, the bank projects French growth potential at a tepid 1 percent a year.

France's national statistics office is a bit more optimistic, but this week it revised down the country's potential annual growth rate to a range of 1.2 percent to 1.9 percent. Between 1999 and 2007 it averaged 2.2 percent.

For the euro zone as a whole, potential growth has declined from 2.4 percent in the 1980s and 2.2 percent in the 1990s to 1.8 percent in the 2000s and just 1 percent on average over the past four years, according to David Mackie with JP Morgan.

To keep the potential growth rate close to or above 1 percent will require a decline in the natural rate of unemployment, beyond which point wage inflation accelerates, as well as noticeably stronger productivity growth.

"Both of these likely require substantial structural reforms across the region," Mackie said in a report.

PAST MISTAKES, FUTURE DISAPPOINTMENT

Nicholas Crafts, an economics professor at Britain's Warwick University, estimates that a package of supply-side reforms to end tax distortions, strengthen competition, reduce red tape and improve the quality of education could add 0.5 to 1 percentage point a year to European growth by 2030.

But there is a hitch. "Generally speaking, this could be done without undermining public finances but not without upsetting many voters," Crafts wrote in the National Institute Economic Review.

Instead he worries that governments will make serious policy errors, as they did, under different circumstances, in response to the Great Depression of the 1930s.

To lessen the drag on growth from high levels of debt bequeathed by the crisis, policymakers will be tempted to cut spending on infrastructure and education, which would further dampen long-term prospects, Crafts said.

He also fears creeping protectionism as well as a serious move toward financial repression, holding down real interest rates to ease debt-servicing costs, by limiting in various ways the free flow of capital between countries.

The fragmentation of capital markets is already a serious concern for the ECB.

As a result, the conventional wisdom, as expressed by the Commission and the Organisation for Economic Cooperation and Development, that longer-term trend growth will be unaffected by the crisis, seems too optimistic, Crafts said.

He believes euro zone growth could turn out well below the OECD's forecast of 1.8 percent a year between 2012 and 2030. There will be no return to business as usual.

"The legacy of the crisis is a number of significant downside risks to long-term European growth which do not yet seem to be widely understood and have not yet been incorporated into projections made by agencies like the OECD," Crafts wrote.